Avoid These Ugly, Risky Stocks

For the moment, the market seems to have settled. We're still down for the year, but the huge and seemingly arbitrary daily swings have quieted a bit.

Does that mean the worst is over? It's unclear. The housing market is still in freefall. Banks are still taking billion-dollar writedowns. And the malaise has hit credit cards -- just this morning, American Express (NYSE: AXP) warned that credit losses may increase.

Yet people say the market bottoms about six months before the economy recovers. Maybe that's what's happening here, maybe not. It's hard to draw a firm conclusion, but it doesn't really matter. There's money to be made regardless.

Hit the lobsIf you're a ghoulish value investor like I am, your first thought after the credit bust was probably something like "I'll bet some huge bargains exist in homebuilding and banking stocks." Those bargains exist, but so do dozens of others, because constant grinding negativity drove down so many great stocks.

Sure, you could make money if you identified the subprime winners, but why bother trying to separate the winners from the losers when great stocks that aren't involved in the bust are cheap right now? The subprime-stained stocks are still too ugly and risky for my dollars. In baseball terms: Don't swing at the fastballs. Aim for the lobs.

There's no reason to spend days figuring out whether MBIA (NYSE: MBI) will recover. That $65 share price is ancient history. Even if the company survives, share value has been diluted, and the bond insurance business may be completely different once regulatory discussions turn to action. Predicting this one is way too hard.

Similarly, steer clear of the investment banks. If one of them can collapse in a matter of days, who's to say another won't? Avoid banks like First Horizon (NYSE: FHN) until you're confident that the worst is over.

And DR Horton (NYSE: DHI) and the other homebuilders? I wouldn't go near them until there's actually some evidence that the housing market has bottomed.

Cheap and easyThough the market isn't acting like it, the long-term prospects of most companies aren't significantly affected by the credit crisis. If we're in a recession, it will have a short-term impact on most businesses, but it won't last forever. So forget the lenders. Instead, go after the stocks that are also cheap, but don't have the same long-term risks.

For example, 3M is a giant conglomerate that produces everything from Post-it Notes to metered-dose drug inhalers to touch-screen monitors. A U.S. recession will slightly ding short-term earnings, but this is a company with more than 55,000 products and international sales of $15.5 billion.

Yet this stock has fallen about 25% from its highs and is trading at its lowest price-to-earnings multiple since 1998.

Health-care companies have been hit hard, too. WellPoint (NYSE: WLP) is trading at less than 10 times earnings, even though it has a lot of cash on the balance sheet, high returns on equity, and good growth prospects. Similarly, Coventry Health Care (NYSE: CVH) is trading at a multiple of about 8. The market is worried about rising medical costs. Health care is a high-profile issue right now, too -- there are few topics that politicians love to complain about more during an election campaign (and do less about when actually elected) than our nation's medical system.

But I don't believe these are anything other than short-term problems. Health care companies will reevaluate their models, adjust to any new regulations, and go back to printing money. Yet because of the market climate, both of these stocks are more than 45% off their 52-week highs.

Be careful, thoughThat said, you should still be cautious. The key to investing during a crisis is making sure that the stocks you're buying truly are isolated from the blow-up. One huge company has failed, others could follow, and challenging credit conditions may have far-reaching implications.

For instance, though interest rates are low, it will be much harder to roll over debt with the credit market at a standstill. Examine the balance sheet carefully, and make sure the company doesn't have significant debt that it needs to roll over in the next few years. When lenders get scared, it doesn't matter if you're a "good" credit risk -- you won't be getting money at attractive terms.

Another item to inspect is accounts receivable. Is the company doing business with people who will have a hard time paying their bills? In a credit crisis, you want to own businesses with rock-solid balance sheets and reliable customers.

The Foolish bottom lineVolatility is frustrating, but it has benefits, too. You rarely get the opportunity to buy excellent businesses at massive discounts to their fair value, but this is one of those times.

Our Inside Value team has found stocks trading 40% or more below their fair value. If you're interested in seeing the ones we recommend, join us for a 30-day free trial.

This article was first published May 2, 2008. It has been updated.

Every now and then, Fool contributor Richard Gibbons gets a little bit terrified, and then he sees the look in Jim Cramer's eyes. He owns shares of WellPoint. American Express, 3M, and WellPoint are Inside Value recommendations. First Horizon is an Income Investor pick. Coventry is a Stock Advisor selection. The Fool disclosure policy is like a shadow on him all of the time.

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